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Pension Plan Investments 2007: Current Perspectives
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ISDAs & PRIME BROKERAGE
AGREEMENTS: THE FIVE MOST
TEDIOUS ERISA ISSUES
Edmond FitzGerald
Davis Polk & Wardwell
ISDAs & Prime Brokerage Agreements:
The Five Most Tedious ERISA Issues
Edmond FitzGerald
Davis Polk & Wardwell
March 14, 2007
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ISDAs & Prime Brokerage Agreements:
The Five Most Tedious ERISA Issues
Introduction. This outline summarizes the five most nettlesome issues that arise
in negotiating prime brokerage and ISDA documentation between a broker-dealer
or bank and a plan or other plan asset customer or counterparty. These issues tend
to be tedious not because they are necessarily unimportant, but because they can
generate a considerable amount of fundamental disagreement on highly technical
points and often stand in the way of finalizing the documentation after all the
significant issues have been resolved. Thus, the bad news is that there is no
universally accepted treatment of these issues, but the good news is that ERISA
practitioners do appear to be trending toward a reasonable, standardized approach
to addressing these issues.
For purposes of this outline, the acronym “B/D” is used to refer to both brokerdealers and banks and the term “plan” is used to refer to both a single plan
account and a pooled ERISA investment fund including several plans.
1. Use of Collateral
Uncertainty Whether Collateral Is Plan Assets. In a prime brokerage or ISDA
relationship, where a plan posts assets to a particular account and agrees that those
assets will serve as collateral for amounts that might be owed by the plan to the
B/D under an arrangement or transaction, there is some uncertainty as to whether
the collateral might continue to be regarded as plan assets as a matter of ERISA
law. The level of uncertainty will depend on the facts. There is precious little
guidance under ERISA in this area.
Principles of Title and Control May Not Be Relevant. In many cases, when
collateral is posted by a plan in a brokerage or ISDA relationship, the plan retains
title and much of the attendant ownership rights in the collateral. The B/D often
receives only some form of security interest in the property and, possibly, a right
to rehypothicate the collateral. An ERISA practitioner can have hours-long
discussions with his or her credit lawyer colleagues and come no closer to a
conclusion as to whether collateral in a particular arrangement is or is not likely to
be treated as plan assets under ERISA. It is not clear whether the principles of
title, dominion and ownership should be given particular relevance in an ERISA
plan asset analysis. The ERISA question is whether the collateral should be
subject to ERISA rules in the hands of the lender to whom they have been posted
or the hands of a third party to whom the lender has rehypothicated the assets.
While for some purposes the plan should continue to have legal rights ownership
and return of the assets, it seems a separate question as to whether the assets ought
to continue to be treated as plan assets for purposes of the various technical rules
of ERISA.
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Implications of Collateral Being Viewed as Plan Assets. The determination of
whether particular collateral is or is not to be treated as plan assets under ERISA
could have considerable impact. If the collateral is plan assets:

will the counterparty or custodian of the collateral be subject to the
various basic rules of ERISA (e.g., bonding requirements)?

will the arrangement violate the requirement that plan assets be
held in trust?

will the counterparty/custodian need to be concerned about basic
prohibited transaction restrictions if it seeks to rehypothicate the
collateral?

will the counterparty/custodian be regarded as ERISA fiduciary
and held to fiduciary standards in its holding, investment and
rehypothication of the collateral?
Perspectives. There are essentially three distinct perspectives on the question of
whether collateral posted by a plan should be regarded as plan assets:
Perspective 1: Not Plan Assets – The assets posted to a collateral account or
subject to a collateral arrangement are not plan assets, regardless of whether the
assets bear any relationship to the outstanding credit taken by the plan against the
collateral on any given day (i.e., even if on a particular day a collateral account
contains $200 million and on that day the plan has only $50 million dollars of
credit outstanding against the collateral, the entire $200 million should not be
treated as plan assets). This view is based on several arguments, which are sent
forth below:

the plan has agreed that the full amount of the collateral account
should serve as collateral at the disposal of the credit provider and
the plan’s asset is not the collateral but the contractual right to the
return of the collateral;

by contract, the plan’s asset is its ability to take credit on demand
from the credit provider, and therefore while that contract
continues to exist and the credit continues to be available, the
plan’s asset is not the collateral assets per se, but is instead the
plan’s right to take credit when desired;

the plan’s agreement to allow its assets to be treated as collateral,
and be subject to rehypothication by the credit provider, is part of
the plan’s overall bargain with the credit provider which was
presumably agreed by the plan in return for favorable liquidity,
interest and fee terms offered by the credit provider (i.e., the plan
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consciously traded its rights in the collateral assets in exchange for
agreed terms).
Perspective 2: A Portion of the Collateral Is Not Plan Assets – A proportion of
the collateral which bears a reasonable relationship to the plan’s outstanding
credit at a particular moment (e.g., collateral with a value equal to 150% of the
outstanding credit) should be treated as assets of the credit provider, but any
collateral in excess of that amount should continue to be regarded as plan assets.
Proponents of this view emphasize that the only instances in which the DOL has
officially opined that collateral posted by a plan would not be regarded as plan
assets involved collateral arrangements under regulatory regimes which limit the
collateral required to cover a margin obligation (see DOL Ad. Ops. 83-62 (Sept.
21, 1982) and 83-62 (Dec. 13, 1983)).
Perspective 3: Rehypothication – Same as above, except that if the credit
provider has been granted the right to rehypothicate all of the assets of the
collateral account then the assets to be treated as assets of the credit provider (i.e.,
not plan assets) at any given moment should include not only the assets
constituting the chosen loan percentage but any additional assets as to which the
credit provider has exercised its right of rehypothication. For example, if the plan
had taken credit of $1 million and the credit provider had rehypothicated $1.5
million of the collateral assets, the credit provider should not be required to return
assets to the collateral account at a later date merely because the plan has reduced
its leverage to $500 thousand, because the plan could very well increase its
leverage to $1.6 million the next day.
Customary Practice. Although there continues to be disagreement, ERISA
practitioners typically do as follows:

permit the parties to agree that the collateral assets will not be
regarded as plan assets.

advise the B/D to:

adopt a standard ratio of credit-to-rehypothication, and

hold the non-rehypothicated assets as plan assets.
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2. QPAM Appointment
QPAM Representation Required. Although the patchwork of prohibited
transaction exemptions that are available under ERISA and the DOL prohibited
transaction class exemptions applicable to B/Ds might provide adequate relief for
the standard variety of transactions under a prime brokerage arrangement, B/Ds
still require asset managers of plans to execute transactions in compliance with
the broad relief provided under the DOL’s qualified professional asset manager
exemption (PTCE 84-14) (the “QPAM Exemption”). By requiring
representations in the prime brokerage agreement establishing that transactions
will generally qualify for the relief of the QPAM Exemption, B/Ds relieve
themselves of the concern of having to monitor whether any particular transaction
satisfies the requirements of another limited exemption. And in the case of ISDA
transactions, it is even more important to operate under the QPAM Exemption
because the other exemptions might not provide the necessary relief.
Scope of QPAM Representation. Ideally, a B/D would prefer that its prime
brokerage or ISDA master agreement with a plan include a representation by the
plan that the agreement and each transaction thereunder will satisfy all of the
requirements of the QPAM Exemption. However, the plan fiduciary will often
request that the parties share the risks and burden of complying with two of the
requirements of the QPAM Exemption.
The first is the requirement under Part I(a) of the QPAM Exemption that neither
the B/D nor its affiliates may have been responsible for placing under the
management of plan fiduciary who is entering into the transactions with the B/D
any of the plan assets that will be involved in the transaction. If the plan assets
involved in the transaction are part of a pooled investment fund which may
include numerous plan investors (e.g., a hedge fund), this makes it more difficult
for the fiduciary to ensure that neither the B/D nor any of its affiliates have placed
a plan into the pooled fund and thereby appointed the fiduciary.
Some relief is provided by a clause in the QPAM Exemption which excepts from
this appointment any plan which constitutes less than 10% of a pooled fund.
However, this 10% exception is not complete relief because many early stage
funds expect that they might initially have plan investors which represent over
10% of the fund, and even mature funds cannot predict if they might have a 10%
plan investor at some future date.
In addition, the appointment requirement under Part I(a), the QPAM Exemption
includes a provision (Part I(d)) which requires that the B/D with whom a plan is
transacting not be related to the fiduciary causing the transaction. The definition
“related” for this purpose includes some rather remote relationships, again making
fiduciaries concerned about bearing the sale risk and burden for ensuring
compliance with this condition.
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Developing Practice. In the recent past it was not uncommon for the
representations of a B/D and a fiduciary to get into protracted negotiations about
allocating responsibility for compliance with the affiliation conditions of the
QPAM Exemption. These discussions sometimes resulted in detailed contractual
provisions requiring information sharing and checks to monitor potential
affiliations. While these types of arrangements might still be encountered,
fortunately the majority seems to have settled on a shorter, more reasonable
approach under which the B/D and the fiduciary mutually agree to use reasonable
efforts to monitor compliance with the requirements of Parts I(a) and I(d) (or
words to that effect) and the fiduciary provides a flat representation that the other
conditions of the QPAM Exemption will be satisfied.
3. Inadvertent Prohibited Transactions
Potentially Prohibited Transactions. Particularly in prime brokerage relationships,
the B/D and other service providers might engage in transactions with the plan
account which are more in the nature of ancillary transactions than primary
transactions specifically negotiated by the plan fiduciary. This might happen, for
example, when a B/D automatically provides credit to cover short sales or
purchases where the account does not hold enough cash of the proper currency to
cover, or where the B/D appoints sub-custodians (e.g., affiliates) to hold collateral
or other account assets in a non-U.S. market. There may be strong arguments that
the provision of these conveniences: (1) does not entail a fiduciary act by the
B/D, (2) should be exempt as subsidiary transactions under the QPAM Exemption
or (3) might be covered by other available exemptions.
Disagreement as to the Contractual Remedy. Nevertheless, a B/D will often
request that the prime brokerage agreement with a plan include standing
instructions from the plan fiduciary authorizing these automatic transactions
where necessary to carry out the intent of the agreement and the specific trades
directed by the fiduciary. The fiduciary might object to provisions entailing
standing instructions on any number of grounds, including assertions that such
provisions contradict the QPAM representation that the fiduciary is being required
to provide, in that the QPAM Exemption requires all transactions to be negotiated
and approved by the QPAM.
4. Additional Termination Events
Overlapping Representations and ATEs. Often the most tedious exercise in
negotiating the Additional Termination Events in an ISDA master agreement is
distinguishing whether a particular event should be covered as an ATE or as
representation.
It is not uncommon for an ISDA master agreement to include a representation
from the plan counterparty that all transactions under the agreement will be
exempt from ERISA’s prohibited transaction rules by virtue of the QPAM
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Exemption. It is also not particularly uncommon for the B/D to request that the
same agreement include as an ATE the occurrence of any transaction which does
not comply with the QPAM Exemption. If both these provisions were included in
the same ISDA agreement, the occurrence of a transaction which did not comply
with the QPAM Exemption would result in a breach of a representation (a default)
and an ATE. The remedies applicable to a default and an ATE are usually
different. For example, under the 2002 ISDA master agreement, the following
effects typically apply:
Default – A default typically allows the non-defaulting party to:

close out all outstanding transaction on not more than 20 days
notice;

immediately suspend its payment and delivery obligations with
respect to all transactions;

hold back any collateral; and

the non-defaulting party typically determines the closeout amount
using market quotes and, perhaps, its own information, although it
must do so in good faith using commercially reasonable methods
producing a reasonable result.
ATE – The remedies and procedures upon occurrence of an ATE depend
on whether one or both parties have been designated in the ISDA
agreement as “affected parties” with respect to the ATE. Where the plan
is designated as the sole affected party, typically:

the plan (as affected party) must notify the B/D promptly upon
becoming aware of the existence of an ATE;

the B/D (non-affected party) may closeout any “affected
transactions” (i.e., not all transactions) on not more than 20 days
notice to the plan;

but the B/D has no right to suspend payment or delivery or return
of collateral; and

the B/D (the non-affected party) calculates the settlement amount
for the close-out of the affected transactions. If both parties have
been designated as affected parties, both parties calculate the
settlement amount and the average of the two is typically used.
ATEs and Representations with Slight Differences. While it might seems at
first blush that an ATE provision in a proposed ISDA agreement entails
precisely the same event that is the subject of a representation in the ISDA
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agreement, on closer inspection the two provisions might cover slightly
different events.
For example, as discussed in topic 3 above, a QPAM representation in an
ISDA agreement might state that the B/D and the plan will both use
reasonable efforts to ensure that the conditions of Parts I(a) and I(d) of the
QPAM Exemption are met, and the plan counterparty might provide a flat
assurance that the other conditions of the QPAM Exemption will be met with
respect to each transaction. Then the ATE provisions of the ISDA agreement
might state that any transaction that involves a prohibited transaction under
ERISA will trigger an ATE. In this case, if a transaction involves a prohibited
transaction because the conditions of Parts I(a) or I(d) of the QPAM
Exemption were not satisfied this might not trigger a default but rather an
ATE. This would have a less Draconian effect for the plan counterparty
(particularly if both parties had been designated as affected parties) and would
permit the parties to negotiate an early settlement of the affected transaction(s)
without necessarily forcing the conclusion that a prohibited transaction had in
fact occurred, assuming there is a reasonable basis to conclude that a
prohibited transaction had not occurred (e.g., there is reason to believe that the
B/D is not a party in interest to the relevant plan(s) involved in the ISDA
transaction).
The foregoing is merely an example of a case involving a similar yet distinct
representation and ATE. Often, the distinctions are often more subtle and less
obviously intentional or useful, which is often what makes this exercise so
tedious.
Duplicative ATEs and Representations. In other cases, a representation and
an ATE are coextensive, leaving one of the parties to wonder whether this was
an intentional move by the other party, and whether to object or leave it be.
An ATE provides a contractual foundation for the parties to avoid triggering a
default and closing out all transactions and to instead agree that only certain
potentially affected transactions will be settled early, again avoiding the
inference that a prohibited transaction has occurred, assuming there is
otherwise a reasonable basis to conclude that one has not in fact occurred.
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5. Indemnities
Whether the Fiduciary Should Be Asked to Provide Representations and
Indemnities. In preparing a prime brokerage agreement for a plan counterparty, a
B/D frequently asks itself:

whether it will require the plan fiduciary to make certain
representations together with the plan and, if so, which
representation; and

whether it will ask the fiduciary to provide its own indemnification
for any breach of the representations.
Arguments of the Fiduciary Against the Need for Fiduciary Representations and
Indemnities. In arguing against giving its own representations and certainly in
arguing against an indemnification, the fiduciary might assert that:

The B/D can get all necessary protection from the plan. Although
ERISA places limits on the indemnities that a fiduciary can extract
from a plan, nothing prevents a non-fiduciary B/D from recovering
from a plan in the event of a breach of a representation given by
the plan.

The fiduciary is not in the business of giving personal assurances
and back-stops concerning its clients, and traditionally fiduciaries
have not been required to do so as a matter of commercial practice.
Arguments of the B/D in Favor of Fiduciary Representations and Indemnities.
From the B/D’s perspective, having the fiduciary commit to representations and
provide an indemnity might not necessarily add much, since many fiduciaries are
thinly capitalized and routinely withdraw or protect any revenue streams
generated by their operations. Nevertheless, there may be instances where the
fiduciary’s assets or its errors and omissions insurance might provide a preferred
or additional source of recovery. The B/D might argue:

A court might prevent a B/D from recovering from a plan when the
cause of the B/D’s damages is a fiduciary’s negligence. Where the
fiduciary represents a fund that includes some plan investors and
those investors are successful in avoiding contributing to a B/D’s
recovery against the fund, the assets or insurance of the B/D might
help to fill the gap.

By having the fiduciary commit to representations and an
indemnity it: (1) causes the fiduciary to be thoughtful about the
provisions it is agreeing to and (2) provides a disincentive for the
fiduciary to later allow its plan clients to escape contributing to
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making the B/D whole for damages it may suffer from the plan’s
breach of the agreement.
As a result of the legal uncertainties as to whether plans might indeed be
permitted to escape contributing to making the B/D whole for damages, and
fiduciaries’ resistance to providing back-stop indemnities, the negotiation of an
indemnity can become a rather tedious exercise.
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